Financial traders use correlation to describe the movement of securities – how and when they move – relative to each other during a given time period. These relationships lend themselves well to pairs trading, where traders have developed an understanding of correlations and their behavior that allow them to confidently exploit slight changes to minimize risk and maximize profitable transactions.
Positive, Negative, and No Correlation
Correlations are not permanent relationships. They are reflective of specific periods of time, and a close correlation at one point may shift in the future. There are three main types: positive, negative, and no correlation.
When two securities have a positive correlation, they tend to move in the same direction. A positive correlation is a represented by a number between 0 and 1 (or sometimes a percentage between 0 and 100%; in either case, the number is calculated through data about the asset’s historical performance). The closer to +1 the correlation, the stronger a correlation is said to be (and the more the securities will move in lockstep).
Two assets that move in opposition to each other are said to have a negative correlation (between 0 and -1). For example, a -.6 (or -60%) correlation means the assets had opposite trajectories 60% of the time. No correlation (or zero correlation, though it can be a number very close to zero) means there is no obvious correlation in behavior between two assets.
Trading Strategy
Correlation trading is heavily dependent on timing – quickly recognizing a breakdown is vital to avoiding heavy losses (or earning significant gains). Some traders will balance their portfolios in tumultuous markets by pairing assets with a positive correlation and assets with a negative correlation. This reduces overall risk by balancing out the effects of each asset. While this approach potentially limits returns during that time, a trader can then counterbalance it when the market is more advantageous.
Key to this method is recognizing and tracking certain common correlations between various assets. Some currencies, like the Canadian dollar (CAD), are heavily correlated to oil prices (oil being one of Canada’s primary exports); airline stocks and oil prices are often correlated, while the S&P 500 and large-cap mutual funds also have a positive correlation. Investors who recognize these correlations can often use the movement of one asset’s price to reasonably predict the direction of a correlated asset’s price.
Why is Correlation Important?
Asset correlation can help traders smooth out portfolio volatility, allowing for high risk and return investments. Optimizing a portfolio with low and high correlation assets allows a trader the chance to succeed in any market, avoiding peaks and valleys while still offering chances to hit it big under the right conditions.